It is beyond doubt that the value of any accounting standard is in direct propor- tion to its service of, and support for, core variables and their impact on a com- pany’s staying power, as well as on the economy as a whole. According to ECB, the top five core variables are:13
● Earning ratio
● Solvency ratio
● Leverage
● Firm size, and
● Age of firm.
Earningshould be seen relative to total assets. Higher profits are not only good for shareholders. They are sought after because they imply a lower likelihood of financial distress. The solvency ratiois computed as shareholder funds relative to total assets. This provides information on the ability of a firm to generate sat- isfactory earnings in past years. The past, however, is not a predictor of the future; that is why we need forward-looking statements (see Chapter 10).
Leverage is debt over total assets. A high level of leverage implies instability in ownership of funds. Another negative is that when companies get into difficul- ties it is not easy to service and repay their loans, bonds, and other financial obli- gations – no matter what different eggheads may say about debt being preferable to equity.14
Thinking by analogy, the ECB study characterizes firm size as the logarithm of total assets, with the additional characteristics that older firms tend to be larger than newer firms. Based on the effect of firm size, ECB advances the hypothesis that:
● An optimal firm size does not exist, hence there is a trade-off between being relatively small and being relatively large.
The ECB suggests that this would indicate that the effect of firm size on the prob- ability of experiencing financial distress is nearly U-shaped because small firms have a higher probability of falling into financial difficulties as they are not as resistant to the shocks they might encounter. On the other hand, larger firms also have a high probability of falling into distress, if:
● They are inflexible
● Have serious management problems, or
● Lose contact with the market, as IBM did in the 1980s.
ECB’s U-curve is a very interesting concept and it finds its counterpart in relia- bility engineering (see section 5). As Figure 2.5 shows, teething troubles and baby failures are encountered at an early stage.15But towards the end of useful life there are worn-out failures:
● Man-made products wear out, as one knows from one’s car, oven, or refrig- erator; also from failures with space shuttles.
● The management of companies also wears out, after the innovators and promoters are gone. When the fat cats take over, all they care for is their own survival, not the company’s, as witnessed by the fat options they lav- ishly distribute to themselves.16
According to that same study, the fifth core variable is the age of the firm. Other things being equal, age helps in survival. With all due respect, this is pure theory.
Of the 100 largest US firms quoted on the New York Stock Exchange in 1910, almost a century ago, only one is still in the top-100 list: General Electric. The others dropped out, and the majority disappeared.
The way theorists have it, firms learn about their ‘efficiency’ as they operate in the industry. In practice, firms create inefficiencies as they operate. Look at General Motors. Also according to theory, firms know the average level of market prof- itability, but they do not know their own potential. In practice, they know neither.
This blue sky has its counterpart in another theory that the probability of financial distress decreases along with an increase in firm size. General Motors, Ford, Fiat, not to mention Enron, WorldCom and Parmalat suggest precisely the opposite. But creating silly theories like the Modigliani–Miller ‘debt is good for you’ hypothesis can win you a Nobel prize – hence it serves a purpose, albeit a personal one.
Leaving aside then the fifth core value, and concentrating on the first four, we can see that IFRS contributes to providing corporate governance with a compass much more reliable than that given by the old method of accruals. This is self-evident with earnings, solvency, and leverage. Regarding size, I would only make the remark that:
● A crucial factor entering firm size should be its capitalization, which is a way of marking to market its assets
● But at the same time, very slow and very rapid increase in capitalization, as in the case of Enron, Global Crossing, WorldCom, and others, suggests that the company is moving up the right leg of the U-curve in Figure 2.5, because of a rapidly developing fat cat syndrome.
The list of core values in corporate governance can be improved by the addition of another bullet point: top management accountability. The Basel Committee on
RISK OF FAILURE
HIGH MORTALITY BABY FAILURES TEETHING TROUBLE
HIGH MORTALITY WEAR-OUT FAILURES FAT CAT SYNDROME
LOW MORTALITY RELATIVELY STEADY STATE HIGH
LOW
TIME
Figure 2.5 All systems, all products, and all entities go through a U-curve transition in mortality
Banking Supervision says that much when, in its supervisory guidance on the use of the fair value option, it states that: ‘The Committee acknowledges that the responsibility for financial reporting also may rest with the board of directors and that the responsibility may vary by jurisdiction. Accordingly, “senior man- agement” here refers to the parties that are responsible for financial reporting in any given jurisdiction.’17
In the summary of the recommended 17 best policies and methods regarding governance, control, price verification, and audit practices for enhancing public confidence in public reporting, the Basel Committee further notes that a clear and delineated governance structure should exist, including provision for:
● Appropriate segregation of duties, and
● Documented procedures for escalation of issues and exceptions to the board of directors or the audit committee. (The role of the audit committee is discussed in Chapter 17.)
Another point made in the same document is that a senior management group- ing should have responsibility for the governance and oversight of control and valuation policies and procedures. This group should report the results of its work directly to the board of directors or the audit committee. Moreover,
● Initial responsibility for the determination of fair value should reside with the risk-taking business, and
● Ultimate responsibility for determining the fair values incorporated into financial statements must be outside the risk-taking functions.
In short, it is the Basel Committee’s thesis that senior management should assure there are adequate human resources, with appropriate experience, training, and reward to guarantee that internal control, risk management, and independent price verification functions are performed to the highest standards. This is a mat- ter not only of corporate accountability but also, and most particularly, of per- sonal accountability. In a way, it is on a par with reliable financial reporting, as we will see in Chapter 11 in connection to the US Sarbanes–Oxley Act.